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lsoc-1528 copy

lsoc-1528 copy

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12/04/2012

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34
 Futures Industry
|
www.futuresindustry.com
 T 
he primary goal of LSOC is to pro-tect cleared swaps customers from“fellow customer risk”—the risk thatcustomers of an FCM could sustain losses if other customers of that same firm fail to sat-isfy payment obligations to the firm. LSOCis di
ff 
erent from the traditional customersegregation model for futures accounts inmany ways.
e LSOC rules were approved by theCFTC in January, and compliance wasmandated by Nov. 8. However, it has takenmonths of discussions among market par-ticipants, including central counterparties(CCPs), sell-side firms, and buy-side firms,to determine how to implement LSOC re-quirements. Because of the tight deadline,the major swaps clearinghouses have eachadopted a phased approach to implement-ing LSOC.
e first phase is set for a Nov.5 launch in a manner that minimizes theoperational and systems work.
e secondphase will then start in 2013. At an FIA workshop held in New York inSeptember, representatives from CCPs andFCMs spent an afternoon discussing how the new LSOC rules will be implementedinitially. CME, ICE and LCH.Clearnet rep-resentatives explained their plans for imple-menting the new protections.
is is a work in progress,” said ArthurMagnus, managing director, and globalhead of futures and options and OTCclearing core operations at J.P. Morgan, who moderated the September workshop.
What is LSOC?
LSOC is designed to be an extension of the customer segregation model for U.S. fu-tures. In the U.S. futures model, an FCMmust hold customer funds physically sepa-rate from its “house” funds.
is separate
In November U.S. futures commission merchants and swaps clearinghouses will begin offering a newcustomer protection regime that differs from the traditional futures segregation model. This new customerprotection model, called Legally Segregated Operationally Commingled, or LSOC, is a requirementestablished by Commodity Futures Trading Commission rules under the Dodd-Frank reforms. LSOCapplies only to customer positions in cleared products that are in the U.S. swaps regulatory class,such as interest-rate swaps, credit-default swaps, and FX and commodity swaps and forwards. LSOCdoes not apply to futures.
 
 An LSOC Tutorial: A New CustomerProtection Model forCleared Swaps Begins
By Joanne Morrison
 
Futures Industry 
|
 November 2012 
35
pool of assets is called the “segregated fundspool.” At all times the firm must ensure thatit maintains at least as much value in thesegregated funds pool as is required to coverits liabilities to customers. Because the firmmust often meet obligations of its customersto clearinghouses before it can collect fromthose customers, it must add a significantcushion of its own assets into the segregatedfunds pool.
e bank accounts or custody accountsthat hold client assets, whether at the FCMor at a clearinghouse, are often referred toas “client omnibus accounts,” because they hold assets of many individual customerspooled together.Each day the FCM must perform a “seg-regation calculation” in which it verifies thatit is in compliance with the segregation re-quirements.
e FCM must file a daily elec-tronic report showing its segregation calcu-lation with its designated self-regulatory organization, and under newly-adoptedDSRO regulations, the DSRO must beprovided with electronic access to the firm’sbank accounts to be able to verify that thefunds are there.Under LSOC, as applied to customerpositions in cleared swaps, the firm mustperform a daily segregation calculation inexactly the same way as it does for futures. And client assets are still pooled together,exactly as with futures. However, the FCMmust assure the clearinghouse that whenit meets a margin call to a clearinghousefor customer positions, it never uses valueprovided by one customer to meet an ob-ligation of another customer.
is requiresFCMs to perform a more precise calcula-tion of each customer’s obligations to theclearinghouse.If one or more customers were to defaultto the FCM, and the FCM, in turn, de-faulted to a clearinghouse in the customerorigin, the clearinghouse can use value at-tributable to a particular customer only tocure losses of that customer—and not forany other customer.To achieve these results, there are threekey operational implications: 1) Clientsmust be identified to each clearinghouseat which they hold positions, 2)
e clear-inghouse must know the specific positionsof each client, and 3)
e collateral valuefor each client on deposit with the clearing-house must be reported by the FCM to thatclearinghouse at least daily.Because it is critical for the clearinghouseto know the collateral value of each client,the CFTC’s LSOC regulations focus exten-sively on the question of “excess” collateral—i.e., collateral value provided by the cli-ent in excess of the minimum initial marginrequirement for that client.
e regulationsprovide each clearinghouse with a choice.In the first alternative, the CCP may al-low FCMs to pass a client’s collateral valueto the CCP in excess of the client’s mini-mum margin requirement. If so, however,the CCP must provide the FCM with a means to provide a daily report of thatvalue.
is is called “client-specific collateralvalue reporting. Alternatively, the CCP could elect notto support client-specific collateral value re-porting.
is latter choice is referred to asthe “no excess” model or the “unallocatedexcess” model. In this model, the protectedvalue for each customer is defined as theclient’s initial margin requirement, and theCCP does not know the customer-specificattribution of any excess collateral valuethat the FCM provides to the CCP. If theFCM were to default to the CCP in the cus-tomer origin, the CCP could not use thatunallocated excess value to cure losses of any customers, and would have to return it to a bankruptcy trustee when directed to for thebenefit of the clients.Because of the tight deadlines, all threemajor swaps CCPs have elected to imple-ment LSOC first in the “no excess” or “un-allocated excess” model but will make the“client-specific excess” model available toFCMs and customers in 2013.
Client Identification,Onboarding andPosition Reporting
 All three CCPs indicated that they donot expect the processes for client identi-fication, onboarding or position reporting to change significantly, and that they arealready in compliance with these aspects of the LSOC rules.
e LSOC regime requires FCMs toidentify each customer to the clearinghousethe first time that the FCM clears a swapfor that customer and then to provide in-formation to the clearinghouse to identify the customer’s positions at least once eachbusiness day.Helen Fermor, credit business managerat ICE Clear Credit, explained that from anICE perspective, when an FCM onboardsnew clients, it is required to identify the cli-ent legal entity. “We call it a desk ID and we assign that to the client legal entity,” shesaid. “So there should be no change to theclient onboarding process.”
e CFTC’s LSOC rule requires thepositions of each client to be disclosed tothe clearinghouse at least once per day.
isrule is embodied in the regulatory languagethat refers to the client’s “portfolio of rightsand obligations.” For swaps products at allthree CCPs, the end client is identified atthe time the trade is submitted for clearing,and hence there is real-time reporting of theportfolio of rights and obligations for eachcustomer.
e FCM’s obligation under thisrule is to reconcile its books and records atleast once per day with the data files pro-vided by the CCPs, which clearing firmsalready do.
The Initial ImplementationPhase of LSOC
LSOC will be implemented in a two-phase approach.Initially, FCMs will be required to op-erate in the so-called “no excess” or “unal-located excess” mode, which is designed to
In this first phase, anyamount of collateralthat the FCM givesto CME in excessof the minimummargin requirement isdeemed unallocatedclient excess. Andin a default, theclearinghouse can’tuse any of that excessto cover any client’slosses.
ED GOGOL,
CME Group

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